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Dividend Cuts: The Ultimate Guide
How to identify them, what to do, and how to avoid them in the future
Last week NorthWest Healthcare Properties REIT (TSX:NWH.un) finally did the inevitable and cut its dividend. The payout was slashed by more than 50%, falling from $0.067 per month to $0.03.
I covered it in a post sent out to free subscribers a few months ago. Here’s what I had to saw about NorthWest’s dividend then:
I’d like to take a victory lap and say I called it but, to be completely honest, this was a potential dividend cut that was visible from outer space. Any competent analyst would have figured it out in about five minutes after just a quick glance at the financials. The company had a lot of variable rate debt in a rising interest rate environment. What did you think was going to happen?
NorthWest also got far too big too fast as it borrowed aggressively to buy assets that they’re now trying to sell to firm up the balance sheet. They went all-in on low interest rates and now it’s coming back to bite them.
The value isn’t really in identifying a dividend cut when it’s obvious. Most anyone can do that and by the time they do, it’s often too late. The market has figured it out and the stock has collapsed. The value is in identifying dividend cuts before they’re obvious, allowing an investor to get out with most of their capital intact.
This is no easy feat, to put it lightly.
Let’s take a closer look at dividend cuts, hopefully giving y’all some strategies you can start to employ to identify them a little earlier than the rest of the market.
The number one piece of advice given in every other article on how to avoid dividend cuts is simple.
To avoid a dividend cut investors must stop chasing yield.
This is a strategy that, like a lot of other things in investing, sounds good until you start digging into it a little bit.
To be clear, I urge everyone reading this to treat a stock with extra large yields cautiously. Simply buying the biggest yields in the market is a strategy that will almost inevitably end in tears.
But here’s where I have a problem with that rule. Simply telling people to stop chasing yield brings up a bunch of follow-up questions:
How much yield is too much?
How do I tell if the yield is too high?
What about stocks that are temporarily weak?
A lot of it is really lazy analysis. Someone will look at a high yield, declare it unsustainable based on nothing more than the yield being high, and then, when the stock does cut the dividend they’ll take a victory lap.
Say 25% of high yield stocks will cut their dividend in the next 12 months. If I declare 100% of high yield stocks are trash that’ll cut their dividend and I get one out of every four right, I’d argue that isn’t necessarily good analysis.
This also puts all the temporary high yielders that fix their problems in the same category as trashy high yielders, which I’d argue isn’t appropriate. After all, temporary high yielders are often a fertile hunting ground for aspiring value investors.
The easiest way to avoid dividend cuts and the drawback of that strategy
The easiest way to avoid dividend cuts is to buy the stocks with the lowest payout ratio.
Many investors do this by focusing on dividend growth stocks. These companies usually have relatively low payout ratios because they’re plowing a bunch of their earnings back into paying for growth. The dividend goes up over time but the payout ratio stays largely the same as the underlying earnings increase.
This is such a great strategy I dedicated a whole model portfolio to it. It works, especially for investors who are more in the accumulation phase of their journey.
But there’s a downfall to that strategy. Generally stocks with strong dividend growth prospects don’t have a big current yield. A 2% dividend is great for someone with decades to wait until retirement, but it’s not ideal for investors looking to live off their dividends today.
What I do to bridge this gap is I have some higher yielding stocks as well as some dividend growers in my portfolio. Put the two together and my overall portfolio yield is around 4%. Combine that with some pretty heavy diversification and I feel like my overall income should grow at 4-5% per year. That’s exactly what I’m looking for.
Identifying problem higher yield stocks
As I mentioned when I talked about the don’t chase yield problem, temporarily high yielders are a fertile hunting ground for the enterprising value investor. I love hunting there.
So how does one go about separating the wheat from the chaff? I do a few different things.
Firstly, I take a look at the situation. I’m generally not very interested in a stock that has turned an 8% yield into a 10% yield. That’s generally too risky, and I want to spend my time looking in a sweeter spot. Most of my time is spent among stocks that were previously yielding in the 4-5% range that are now yielding 5-7%.
I might be missing some gems here, but I’m quite okay with that.
Next, I’ll analyze the earnings. This immediately becomes tricky because, depending on the industry, different earnings metrics are important. A REIT, for example, uses funds from operations as a substitute for earnings, a number that filters out one-time adjustments in the value of the portfolio. A company with large depreciation or amortization expenses — like Premium Brands, which I profiled last week — will use free cash flow as a substitute for earnings. A financial company, like a life insurer, will use a form of adjusted earnings that minimizes the change in value of the underlying portfolio.
And so on.
Like I said, this isn’t easy.
Instead of trying to figure out potential dividend cuts on your own, upgrade your subscription and let me do the work for you. Periodically we’ll take a closer look at various popular dividend cut candidates.
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Two long-form (2,000+ words) articles on under the radar Canadian dividend stocks
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The next thing I look at when analyzing an accidental high yielder is if something has changed recently. Enbridge is a great example — the company recently agreed to acquire three natural gas utilities from Dominion Energy. Investors are worried the additional debt Enbridge will take on from this deal will put the dividend in danger.
This makes the analysis a little extra complicated. You must look at both the existing assets and how the change will affect them.
A big thing affecting a lot of dividend stocks today is higher interest rates. This makes the analysis somewhat simpler, since we’ve narrowed down the issue, but hardly foolproof. At this point there’s really no substitute for digging deep into the latest annual report and seeing the debt situation. You can then make assumptions going forward based on that, except nobody can predict where interest rates are going so there’s at least a small chance your predictions could all be bunk.
I recently did this with Telus and was pretty amazed at what I saw. Telus has, on average, locked in their debt for an average of 12 years. Approximately 20% of its total debt comes due by the end of 2025. That’s not such a bad place to be in a rising interest rate environment.
Ultimately, all this analysis really comes down to this. Predicting dividend cuts in hindsight is pretty easy. It’s a lot harder a year in advance. Therefore the rewards are much greater for someone who can get it right a lot earlier.
How to deal with a cut?
A lot of dividend investors have a simple rule. Once a stock cuts the dividend it gets punted from the portfolio. Get out, loser! Don’t let the door hit you on the way out.
I waver between thinking this is a solid, simple rule and thinking it’s a little too basic.
Most dividend cuts follow a pretty predictable pattern. The stock grinds slowly lower over a few months as investors speculate a dividend cut is near. Then the big event happens and the stock will fall once again as many other dividend holders get out.
The big problem in selling immediately after the dividend cut is that’s often the bottom. Selling pressure is intense as various folks are hitting the sell button. What often happens shortly after that is the stock starts to rebound. It’ll head a little higher after the smoke clears and a new batch of value investors start sniffing.
That’s the best time to sell, in my opinion. But you always run the risk of the rebound simply not happening.
I’ve been known to add to stocks after they cut their dividend, which has had mixed results. I bought Altagas in 2018 after it slashed the payout and it has delivered a total return of 18%+ annually. But I did the same with Algonquin Power after it slashed the payout earlier this year and I’m down about 5%, including dividends.
So that’s been a mixed bag for me, and I don’t think it’s something I’ll pursue much in the future. I’m trying to move more away from my value investor roots. 2013 Nelson was all over stocks that just cut the dividend. 2024 Nelson will just avoid them.
The bottom line
The easiest way for investors to avoid a dividend cut is to put their portfolio into high growth low yield stocks. Even then, a company can stumble and slash their dividend.
For those of us who want a little extra yield, dividend cuts are something we just have to deal with. A well chosen portfolio will minimize the risk of cuts, but things can change. And that’s not even factoring in something like COVID, where scores of companies temporarily cut their dividends.
Investors who are too aggressive in pruning their portfolios for potential dividend cuts face a different problem. They run the risk of selling at the lows and putting the proceeds into a stock trading at its highs — exactly the opposite of what an investor wants to do.
Personally, here’s what I do to try and avoid dividend cuts. I diversify my capital into stocks with strong cash flow, solid moats, and good management. I mix in both high yielders with a little bit of dividend growth and low yielders with more dividend growth, targeting a 4% yield with enough dividend growth to cover inflation (4-5%). In a portfolio like this I’ll eventually screw up and something will cut the dividend. As long as I’m diversified and don’t have too many eggs in one basket, the portfolio itself will do fine.